Deferred consideration in business sales
If you are considering either buying or selling a business, the question of deferred consideration or deferred payment/s may have been raised. Or in other words, after paying a provisional sum on completion, the buyer may wish to pay the balance by instalment over a period of months, or even years. Whilst this is not an uncommon practice, it is important to consider how best to protect both the buyer and seller in these circumstances.
Why consider deferred consideration?
There may be a number of situations where the buyer represents an attractive opportunity but seeks to negotiate payment by instalment. Deferred payments are often appropriate where there are questions about whether the sale price really reflects the true value of the company and projected future profits or where the buyer seeks to keep the seller engaged with the business as a consultant and motivated. In some cases, it may just be that the buyer will not have access to sufficient funds at the point of completion.
In such circumstances, it may be agreed that the buyer pays by instalment, by the issue of shares by the buyer to the seller as an incentive to the seller for his continued performance or by an earn-out (see below). In this post, we are not looking at the issue of shares which is an inherently more risky area and requires additional due diligence
However attractive the proposition, there inevitably will be some risks or disadvantages in a differed consideration sale, particularly for the seller. These include a risk of increased tax or different tax treatment of the money paid by instalments and the risk that the buyer cannot or does not pay. Therefore it is important to build in safeguards into the sale agreement when negotiating terms.
Due diligence will always be required on the seller’s behalf as to the extent of the buyer’s true ability to pay.
Protecting the seller
There are a number of mechanisms that should be considered as a method of securing payment and or protecting the seller:
- Percentage paid by deferment. Consideration should be given to how much of the total purchase price is paid on completion and how much is to be paid by deferment. From a seller’s perspective, in most cases, the more paid on completion, the less the risk.
- Security. The seller might require security for the payment of the deferred consideration possibly in the form of a charge over the company itself or over a particular asset. The seller could assess the buyer’s company and personal assets and consider a term that makes any directors of a buying company personally liable in the event that the company does not pay deferred consideration.
- Retention. A retention is a payment to a third party (often to a solicitor) who holds the funds pending the completion of a particular event or for a defined period of time.
- Earn outs. This is a mechanism by which the final price will be determined by the future performance of the company. Clear and careful consideration will need to be given to the goals to be satisfied to receive the deferred consideration.
- Immediate repayment term. The seller should consider insisting on a term providing for immediate payment in full if: an instalment is missed, the buyer is at risk of insolvency, or a guarantor of the deferred payments is at risk of insolvency. In cases of a share sale, this protection should also relate to a target company that is at risk of insolvency or is sold, and situations where the buyer or any guarantor is a company which is sold.
- Priority as a debtor. The seller should consider ensuring in the terms of sale that they have first priority as a debtor over the deferred consideration in the event of administration or winding up
- Right to appoint a receiver. The seller may wish to ensure that in the event of non-payment they can appoint an administrator or a receiver.
- Non-competition clause. The seller may wish to protect against a situation where the buyer buys a company, runs it into the ground and then sets up a similar business taking it with customers, suppliers and staff.
A buyer may wish to negotiate that a deferred payment/s should be set off against any claims the buyer has against the seller or retained against any warranty or indemnity claims that the buyer may make against the seller.
Caution is required on the seller’s account here to safeguard against a buyer who brings unsubstantiated or spurious claims against the seller to avoid payment or delayed payment pending resolution. In such circumstances, the seller should consider:
- Payment into an escrow account. Similar to a retention, provision can be made for a deferred payment to be paid into an escrow account until the claim is resolved.
- Provision for the resolution of the claim. To avoid lengthy delays and possible legal proceedings, provision could be made for the matter to be determined by an independent party within a given timeframe.
- Provision to progress any claims. Provision could be made for any claims to be brought within a defined period failing which the deferred payment falls due.
There is never a one size fits all solution in the case of a business sale and deferred payments and each sale needs careful consideration of the unique circumstances that apply in order to ensure that both parties are properly protected. If you’d like more advice on deferred payments on a business sale, please get in touch.
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